Pretend you’re a wealthy retiree, and you really don’t want to lose money. You might use something called a bond ladder so you have bonds maturing in every year of your retirement. Pretty nice to invest $1 million and have a $50,000 bond mature each year for the next 20 years, right? You might know I used to be a bond trader, and that strategy for investing inspired me to think up a new concept for borrowers called a student loan refinancing ladder.
What is this refinancing ladder and can it help you reach your financial dreams? Funny analogies aside, you can refinance your student loans more than once. We surveyed almost 1,000 Student Loan Planner readers in January 2019, and only 51% of our audience knew that fact.
It’s clear from this comprehensive survey we did that borrowers very rarely refinance more than one time. However, if you use the student loan refinancing ladder strategy, you might become excited to refinance early and often if you know you need to pay down your debt.
What is a student loan refinancing ladder?
When you refinance, you’ll have a minimum payment that you must make every month. While our top three partners on our refinancing page give you the option to pause payments for up to three months, that’s nowhere near as good as up to three years of forbearance protection you have on federal student loans.
Of course, federal student loans also have a very high-interest rate that can often approach 8%.
In our survey, 85% of borrowers feared refinancing for various reasons like potential job loss, recession, having kids, buying a house or practice, or new government forgiveness programs.
How can you mitigate the fear of refinancing while also benefiting from cutting your interest rate?
This is where a student loan refinancing ladder comes into play.
Generally, you start off with a 10, 15, or 20-year fixed rate loan term. That interest rate should range from 4.5% to 6%. You make extra prepayments over and above what the lender requires. This knocks your principal balance down faster than scheduled.
If these prepayments are very high, you’ll reach a point where you could refinance again to a shorter term at a similar monthly payment with a lower interest rate. This allows you to reduce your interest expense and pick up another cash back bonus if you use our referral links.
The benefit you got by starting out with a longer term was increased flexibility to pay less towards your loans if you need to because of a big life event.
Dentists using student loan refinancing ladder to buy a practice
Imagine you owe $200,000 and earn $150,000 per year as an associate dentist. You’ve been out of school for three years, so you know that your REPAYE interest subsidy is over. You also know that you eventually need to pay back your loans in full because your debt to income ratio is well below 1.5 to 1.
However, you know that you need to buy a dental practice to be able to earn enough money to rapidly pay down your debt. Having anything get in the way of the practice ownership goal would be counterproductive. You might only save 1% to 2% by refinancing, which in this case would be $2,000 to $4,000 per year, declining each year you pay down the principal.
Imagine if refinancing got in the way of buying a house or a dental practice. You’d be pretty upset.
Your first inclination might be to choose the 5-year term since that one has the lowest interest rate. However, you’d be looking at a monthly payment of $3,638 assuming a 3.5% refinancing rate. That’s $43,660 per year or over a third of your take-home pay.
That kind of a cash flow commitment might hinder your chances of getting the best practice or mortgage financing.
First rung of the refinancing ladder: A long-term loan
Instead of the five-year, let’s assume you select a 20-year fixed rate through Laurel Road. Instead of a required payment of $3,638 a month, your payment would be $1,404 a month.
As long as you have 5% to 10% of the practice purchase price in liquid assets, no banker is going to bat an eye at a student loan payment well below $2,000 a month.
However, if you had a third of your take home pay going to student debt, that banker might not want to lend to you because you have so much cash going to debt payments outside of your practice. Obviously, bankers want you to have low required payments elsewhere when they’re making you a loan.
I’ve actually seen a borrower who refinanced to a 10-year rate only to have to contact the lender and refinance to a 15 year at a higher rate because his bank didn’t want to give him a mortgage. The percent of his income going to debt was above the 40% threshold that gives some banks concern.
If he had used the student loan refinancing ladder, he wouldn’t have had this issue.
Next rung of the refi ladder: refinancing a second time after big prepayments
Let’s assume our borrower chose that 20-year note and paid $4,000 a month instead of the required $1,404. You can do this with all Student Loan Planner refinancing partners because none of them charge prepayment penalties.
After two years, your balance would be at about $120,000 down from the original $200,000.
Rather than continue making these big payments, let’s assume you check our refi partners again and you find a 10-year fixed rate of 4.5% at Commonbond.
Your required payment would now be $1,244 a month instead of $1,404.
However, you cut your interest rate by 1.25% and you picked up a $500 cash back bonus if you used our link. That means more of your payments are going to principal.
Final step of the ladder: choosing a five-year term with a fixed or variable interest rate
Assume you continue those large over payments of $4,000 per month even though your required payment is much lower. You do this for about 18 months and now have about $60,000 remaining.
While you could ride down that 4% seven-year rate to $0 debt, you might as well try refinancing one more time for a five year fixed or variable interest rate.
When you’re down to a low six or high five-figure sum and you’re making rapid progress towards debt freedom, you can probably afford to take variable interest rate risk. Not so much when you still have your original debt amount and you earn less than you owe.
Assume you could refinance to a five year fixed rate of 3.5% with Earnest or a five-year variable rate of 2.6%.
While variable rates scare people, you should only be afraid if you’re not in a position to rapidly pay down the principal balance. My wife Christine and I refinanced with a 5-year variable rate twice on her $124,000 of student debt.
We could’ve used the excess cash flow to invest instead, but we wanted to be debt free so we used prepayments to rapidly eliminate what she owed since almost all our money went to principal instead of interest at a low five-year variable rate.
We would not have taken that risk if she owed a lot more than her income.
You might even add an optional fourth rung of the ladder where you refinance from a five-year fixed rate to a five-year variable rate. It’s completely up to you.
Why do so few people use a student loan refinancing ladder?
I have to tell you this strategy is awesome for folks who want to minimize their required payment while steadily improving on their interest rate over time.
However, few people use this strategy. Why is this? Allow some data from our refinancing survey of our readers to shed some light.
Proof that borrowers aren’t using this strategy right now
I mentioned earlier that half of SLP readers had no idea you could refinance more than once. That knowledge is pivotal to using a refinancing ladder strategy. Pretend you know this though, what else holds up borrowers from using this approach?
We asked borrowers who had refinanced how many times they had done so. Here’s the result below for over 200 readers.
| Number of Times | Percent |
|---|---|
| 1 | 87% |
| 2 | 10% |
| 3 or More | 3% |
Refinancing twice is uncommon, and refinancing three times or more is pretty rare. Clearly, our readers are not doing this right now, even though I’ve shown you how much you could benefit by keeping your payments in check all while reducing your interest rate and picking up additional cash back bonuses.
How much lower of an interest rate would you need to refinance again?
We asked people in the survey how much of an interest rate improvement they’d need to refinance again. Keep in mind these are Student Loan Planner readers. You are more sophisticated than the typical borrower.
| Improvement Needed | % Who Answered |
|---|---|
| 0% to 0.5% | 3% |
| 0.5% to 1% | 10% |
| 1% to 1.5% | 26% |
| 2% to 2.5% | 26% |
| 2.5% to 3% | 13% |
| Over 3% | 22% |
A staggering majority of you said that you’d need over a 2% interest rate improvement to refinance again. This is highly irrational. Not only are there no costs to refinancing except perhaps 30 min to a couple hours of your time, but there are also negative costs.
You’re saving money on interest and getting a cash back bonus of $200 to $500. If you can find a lower rate of even 0.5%, you should refinance a second time (or third, fourth, etc.)
For the student loan refinancing ladder to work, you need to know about several lenders to be able to facilitate shopping around to find better rates. The majority of our readers only knew about 2 or fewer lenders before discovering this site.
That means you should acquaint yourself with the six partners we primarily work with so you can do a two minute rate check with each one six months to two years after refinancing for the first time.
Use a refinancing ladder to save money in these situations
If you are worried about having to make your monthly payment, you should probably not be refinancing in the first place because of superior government protections given to federal loans.
That said, you might be able to easily cover the 20-year payment without breaking a sweat while the five-year would give you pause.
Any professional going through big life changes like having a baby, moving to a new city, starting a new business, or looking to buy a house could benefit from the flexibility of a well-constructed student loan refinancing ladder.
Sometimes the lender you’re already at will let you refinance again without even leaving, especially if you show them a competitor’s offer.
Never refinance if you should be relying on loan forgiveness. That said, I hope this new strategy opens your eyes to the possibilities that exist thanks to the number of good lenders in the student loan refinancing market.
Have any questions about a student loan refinancing ladder or how to implement the concept in your situation? Comment below and ask!
Refinance student loans and get a bonus in 2020
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